Adjectives, Uber and Internalizers

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Morgan Stanley is changing its annual review process to get rid of the old 1-to-5 ranking scale and instead have reviewers "list up to five adjectives that describe the employees." My assumption is that all the adjectives will be positive -- this started with James Gorman "asking job candidates to name five of their positive attributes" -- but people will quickly figure out which adjectives are a 1 and which are a 5. "Congratulations, Jane, you were rated Aggressive, Committed, Ingratiating, Profitable and Also Profitable; you'll be promoted early." "Sorry, Dave, but you got Friendly, Neat, Epicurean, Warm-Blooded and Existent; clean out your desk by noon."

Meanwhile, Morgan Stanley is offering newly promoted vice-presidents four-week paid sabbaticals, which is just a straightforwardly good idea.

It is tempting to laugh at the recent spate of make-banking-slightly-nicer initiatives, which is why I do, frequently. They are so bureaucratic. People aren't actually happier at work because they get adjectives rather than numbers in their annual reviews. They are happy because they think their work has meaning, or because they like their co-workers, or because they're paid a ton of money. (Actually not the last one, but at least the money keeps them there.) But investment banking is an industry in the midst of an identity crisis as it moves from its aggressive profitable past to its boring utility-like future. You could imagine a pleasant transition in which banks slowly dial down the aggression and risk-taking and long hours until they have transformed into the sleepy utilities of regulators' dreams. Or you could imagine a harsh culture of nostalgic, resentful rebellion against the new rules. Bureaucratizing niceness may be a way to push for the easier transition.

Trading will migrate to hedge funds. Jobs in the back office and stock-research departments will be done by machines. The heavy lifting of funding and capital allocation will shift from banks to giant asset managers, pension funds and sovereign-wealth funds.

Pressure on margins will persist, forcing investment banks to unbundle offerings and start charging for services like research and pricing data that they used to give away to win business.

In short, investment banks will be smaller, more specialized and home to technologists instead of traders. Instead of mastering the universe, they will seek to dominate smaller domains.

And they will be slightly nicer.

Uber.

How long can Uber remain a private company? Its recent random $3.5 billion haul of Saudi cash suggests that the answer might be "forever":

There’s a seemingly endless roster of investors anxious to buy into Kalanick’s vision for upending the transportation sector. "Uber is in a class by itself," said Anand Sanwal, co-founder of CB Insights, a firm that tracks startup investment. "There is insatiable appetite for Uber stock," he said, referring to the company’s ability to continually raise large amounts of money.

Yes, money has been in infinite supply for Uber, its Chinese rival Didi and a tiny minority of other hot startups. At some point, though, after the mutual funds and the hedge funds and the Chinese hedge funds and the Saudi government, even the brightest startups will run out of people to write them checks.

Yes but look. Generically, businesses aren't in business so that their investors can write them checks in perpetuity. The basic business plan of business is:

Investors write us checks.

We do business.

We write investors checks.

That's why there is business. If the investors just wrote all the checks, it would be philanthropy. This leads to lots of confusion. People are endlessly worried about stock buybacks, because they think that the stock market should be a way for businesses to raise money, not to give it back to shareholders. But it has to be both. If the shareholders never got their money back, then why would they put money in in the first place?

Of course over time the balance has shifted. That may be in part a story about declining business investment, but it is also a story about the rise of private markets. It used to be that a company did an initial public offering, investors wrote it checks, it did business, and then eventually it returned money to the investors. Now, generically, the investors write the checks to private companies, the companies do business and go public, and then once they're public they start writing checks to the investors. U.S. non-financial public companies as a whole have been net buyers, not sellers, of their own stocks for the past 20 years. That is, the stock market is no longer a way for public companies to raise money. It's a way for people who previously gave those companies money to cash out.

I'm sure that Uber's venture capitalists will want to cash out eventually. (I'm less sure about the Saudis. What else are they going to do with the money?) Perhaps they can cash out to other private investors. Perhaps Uber will remain private and become so profitable that its investors will be content to sit back and receive dividends, without ever selling their shares. More likely, Uber really will need to go public one day to reward its investors. And maybe Uber will even need to go public to raise money for itself: It seems to be burning cash at an alarming rate, anyway, although nowhere close to the rate at which it raises private money. But in principle the reason that Uber exists, and has a $62.5 billion valuation, is that it has a plan to one day make lots and lots of money. If it can reach that point before burning through the $11 billion it's raised in private markets then it will never need to go public just to fund its business. (That $11 billion is more than, say, Google/Alphabet or Apple ever raised in public offerings, and they're doing okay.) It may want to go public to get rid of some of that funding, though.

Best execution.

The other day I suggested that there were two broad ways to think about high-frequency trading: a market-microstructure view that tries to understand it in terms of the basic economics of market-making, and a conspiracy-theory view that tries to understand it as a series of thieving tricks. (Obviously this is a continuum, and you can mostly believe the market-microstructure view while also objecting to some number of thieving tricks.) The clearest example of this may be "internalization," where retail brokerages send their orders -- often in exchange for payments -- to electronic market makers who execute them. The market-microstructure view here is that retail order flow is relatively uninformed, and so it is cheaper and less risky for a market maker to trade with retail orders than it is to trade with institutional orders, and so the market maker is willing to offer price improvement and/or payment for order flow if it can guarantee that it's only trading with retail orders. The thieving-tricks view is basically that the market maker knows the "real" price of the stock, but can trade with the retail orders at the stale official "SIP" price, and makes its money by arbitraging the difference between the two. I have never seen much evidence for the latter view but people are really into it.

Anyway it seems like authorities are looking into internalization and payment for order flow, because it is hotly controversial and the conspiracy-theory view is so popular. Perhaps they will find evidence to support it. But yesterday the Financial Industry Regulatory Authority fined E*Trade Securities LLC $900,000 for internalization misbehavior, and the case against E*Trade is underwhelming, though suggestive. At the time -- the bad stuff happened in 2011 and 2012 -- E*Trade owned its own electronic market maker, G1 Execution Services, which it has since sold. So it wasn't getting payment for order flow from a market maker; it was the market maker. Or it was one of the market makers; it also routed orders elsewhere. And it had a "Best Execution Committee" to make sure that it was routing orders, to G1 or elsewhere, in ways that gave its customers the best execution of their orders. But the Best Execution Committee was ... not the best:

Specifically, the BEC: (i) did not take into account the internalization model employed by the firm; (ii) relied on execution-quality statistics based on flawed data in assessing the execution quality of the market centers to which it routed its customers' orders; and (iii) was overly reliant on comparisons of the firm's overall execution quality with industry and custom averages, rather than focusing on comparisons to the actual execution quality provided by the market centers to which the firm routed orders.

You could hide a lot of cynically bad stuff in that generic description. Or not: or it could have been doing its job in good faith, in 2011-2012, in ways that Finra no longer finds acceptable. In any case Finra doesn't get any more specific, so it's hard to tell how bad this was. E*trade also "regularly accepted requests from G1X to change its priority in the firm's order routing system and to redirect certain order flow, without making an adequate nor diligent determination of whether these changes would improve the quality of execution." That is: G1, which was owned by E*Trade, wanted to trade with more or fewer or different retail orders, presumably because that would make its own trading more profitable. So it asked E*Trade to change the routing, and E*Trade did, without asking the related but different question of, would that make trading better for its customers.

Yahoo!?

We talked the other day about the Dell appraisal decision, in which a court apparently concluded, a bit oddly, that any private equity leveraged buyout will necessarily pay less than the fair value of a company, just because private equity firms demand above-market returns on their investments. And yet private equity firms buy companies sometimes! And the companies sell, and the shareholders approve the deals. Sometimes private equity buyers even win auctions. Against strategic buyers, even. It's a weird world. Anyway though not at Yahoo, where interest from AT&T "could be a death knell to efforts by private equity firms hoping to acquire the beleaguered internet company":

Private equity firms, which often rely heavily on debt to finance buyouts, realize they would struggle to win a bidding war with well-capitalized acquirers while still generating the types of returns demanded by their investors, according to people familiar with the situation, who asked not to be identified because the information is private.

Private equity bidders will be hampered not only by return expectations but also by limits on their ability to lever up Yahoo. "Given Yahoo’s declining profitability and revenue, lenders aren’t likely to provide financing of more than four times adjusted earnings before interest, taxes, appreciation and amortization," meaning something like $2.5 billion of debt on assets that might go for $4.5 billion, perhaps not enough leverage to make it interesting.

“When you talk about robo and investing, well we can do that, and give it away for free if we want,” Dimon, 60, said Thursday during an investor presentation in New York.

And:

Dimon asked the audience how many would open a Chase account if it came with five to 10 free trades per month. A few raised their hands.

“We’re going to build it anyway, folks, and then we have to decide how to price it,” Dimon said. “But we want to add these great services.”

I suppose the worry for the robo-adviser firms is that robo-advising may end up being a button, not a business. Like, that is the point of robo-advising: It is simple, low-touch, tech-enabled, an app. You don't feel personal loyalty to your robot the way you might to a human financial adviser. If your checking account and mortgage and everything else are at Chase anyway, and its robo-adviser is free, why would you move money to Betterment or Wealthfront and pay for their robots? The counterarguments is that people might trust the nice techie unconflicted robo-advisers more than they trust JPMorgan. But "we're going to build it anyway, folks."

Crime.

Yesterday the Justice Department charged two Deutsche Bank employees with Libor manipulation, which "shows that authorities are continuing to pursue individual bankers eight years after opening investigations into manipulation of the London interbank offered rate." Eight years! Man. The Justice Department's announcement is pretty ominous for those employees:

“Healthy financial markets are crucial to a successful economy,” said Deputy Assistant Attorney General Snyder. “By corrupting this important benchmark rate, the defendants undermined the integrity of financial markets here and around the world. The department is committed to holding individuals accountable for the roles they play in committing complex financial crimes.”

Libor manipulation is, like, someone calls you up and asks you to make up a number, and you make up a number, but instead of making up the number with purity of heart and disinterested intellectual honesty, you make it up based on how it affects your derivatives portfolio. It is a weird crime, or crime-like thing. (The charges are wire fraud and bank fraud, and really everything is wire fraud and most things are bank fraud.) The trick, for prosecutors, is to connect some midlevel traders' somewhat abstract dishonesty to, like, undermining the integrity of financial markets around the world, which "are crucial to a successful economy." They seem to be going big from the beginning.

Meanwhile, Haena Park faces civil and criminal charges that she lied about her success trading futures and foreign exchange "when soliciting friends, family, former Harvard classmates, and individuals with connections to them." Ah, the old Harvard affinity fraud. U.S. Attorney Preet Bharara says that Park "raised more than $23 million from victims and lost nearly all of it," and then Ponzied it up a bit to pay back old investors with new investor money. Elsewhere in Ponzis: "As Koch Brothers Cling to Madoff Cash, a New Legal Battle Arises."

People are worried about unicorns.

I mean, there is the Uber thing. Here is Bloomberg View's Megan McArdle on "What the Saudi Stake in Uber Means for the Unicorn Bubble." More generally, here is Nick Bunker on "What happens if the 'unicorn' bubble bursts?" Elsewhere, Leonardo DiCaprio is on the board of directors of Rubicon, "the Uber of Trash."

People are worried about bond market liquidity.

"Brexit fears jolt sterling bond liquidity." It is sort of a well-known awkward joke that so much of the world is interpreted through the lens of financial markets: "massive plague endangers bond repayments," "nuclear war bad for stocks," that sort of thing. J.W. Mason writes that, "in the higher consciousness of the bourgeoisie, nations and all other social arrangements exist only in order to generate payments to owners of financial assets." But it would be funny if more world events were interpreted specifically through the lens of bond market liquidity.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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